VALLEY OF WONDERS

EVOLUTION OF ROYALTIES

The original Oil Royalties are those reserved by the owner of the petroleum and natural gas rights underlying the tract under development. These, known as "Landowner's Gross Royalty", represent a stipulated percentage of the barrels produced, or the revenue therefrom, and are subject to no deductions whatsoever. They rank prior to all other interests in the well or tract.

So far as Turner Valley is concerned, these Landowner's Royalties include those held by the Crown (the Alberta Government), and the several owners of 'freehold' rights granted by the Crown during the early days of this country. These include the Hudson Bay Company, the Canadian Pacific Railway, the Calgary & Edmonton Corporation, and a few smaller, freehold owners. Only a very small portion of these royalties are held by the general public.

Before the Landowner's Royalty is worth much, the property it covers must be developed. Some of the original owners have put up funds for the development of their own properties. Most however, lease their property to companies and individuals, reserving a 'Landowner's Royalty', charging an annual rental fee, and requiring a commencement of development within some defined period. Those who have acquired the leases may go ahead and develop them, or they may sub-lease the rights to others, who will make the arrangements for development. Handling a lease or sub-lease, especially in proven or semi-proven territory, usually involves considerable expenditure for the purchase of the lease or sub-lease, payment of rentals, etc. The lessors and sub-lessors therefore feel entitles to an equity in the property.

Usually their equity consists of an 'Overriding Gross Royalty". This type of Gross royalty is similar to the Landowner's Gross in that it bears no portion of operating expense. Legally, its only difference is that it is subject to prior payment of the Landowner's Royalty. At one time there was no limit to the amount of Overriding Gross that could be created. Now, however, the Securities Commissions of the several Canadian Provinces stipulate that the Landowner's Gross plus the Overriding Gross must not exceed twenty-five percent.

The remaining interest in the property - now a minimum of 75% - might be transferred to a company which would issue shares to finance drilling or might be spilt up into various types of Net Royalty interests, which would be sold to finance drilling.

Prior to 1939, the usual types of royalty issued to finance drilling were ordinary 'Net Royalties or 'Net Royalty Units'. In the first type, the while ownership of the drill-site was considered as 100%. If Gross Royalties totalled 25% the remaining 75% was split into 75 Net Royalties, each of which was entitled to 1/75th of revenue remaining after payment of Gross royalties and operating expense. In the second type, the interest remaining after Gross Royalties was considered as 100% and was split into 100 net Royalty Units, each entitled to 1/100th of revenue remaining after Gross Royalties and operating expense. This second type is no longer used for financing Turner Valley development, but Net Royalty units are still drawing monthly returns from production of a few older oil wells.

Since 1939, however, the most common type of royalty issued to finance drilling had been the Preferred Net Royalty". Its big advantage from the investor's viewpoint is that it generally ensures a far faster return of the original investment than any other method of financing.

Under this method of financing, the interest remaining after provision for Gross Royalties (let us say 75%) is split into 50% to 55% Preferred Net Royalty and 25% to 20% "Deferred Net Royalty', instead of into 75% ordinary Net Royalty. The Preferred royalty is sold to finance drilling. The Deferred is retained by the sponsors of the venture.

When production is secured, the Trustee for the royalty holders will distribute each month all of the revenue remaining after payment of Gross Royalties and operating expense to the owners of the Preferred Royalties, this being continued until the full original issue price of the Preferred has been repaired. During this period, no distributions are made on the Deferred Royalties. After repayment of the original cost, the Preferred and Deferred Royalties rank as ordinary Net Royalties, and 1% Deferred participates to the same extent as 1% Preferred for the remaining life of the well.

Twenty percent of the original issue price of a Preferred Royalty represents commission allowed the sponsoring dealer by Securities regulations. The remaining eighty percent represents the share of estimated drilling costs to be borne by proceeds from the sale of that royalty. In most cases in the past, the Preffered Royalties provided only for estimated drilling costs, with cost of production equipment and acidizing being met from first net production. Some new issues, however, provide for post-completion costs as well as drilling costs.

POINTERS ON ROYALTY INVESTMENT

Carefully selected, Turner Valley Oil Royalties offer both an attractive speculation and an investment.

An 'Ahead-of-the-Drill' Royalty, bought during the initial financing stage or while drilling is in progress, rates as a speculation. Its value may be subject to considerable fluctuation as neighboring wells are completed and provide an indication of possibilities, as the well's own Log revels promise or perhaps lack of it, and may be considerably enhanced when the well itself is finally brought into production. It is quite common for Drilling royalty values to increase 25% to as much as 100% between the date of spudding in and the date of completion. Such appreciation in value rates as a 'Capital Gain' and as such as not taxable.

A Producing Royalty should be regarded as an investment rather than a speculation. Its market value is not subject to any great fluctuation, other than that resulting from changes in the price of crude, and the price paid for it should be such as will allow the return of investment within a reasonable period, together with a fair profit.

Important to note is that production from wells financed by Royalties is not, unlike that from wells financed by stock issues, subject to taxation other than that in personal income taxes by each Royalty owner. It is not subject to Excess Profits Tax nor to Corporation Taxes. 25% of the income received from producing royalties in exempt from personal income tax.

The prospective purchaser of a Royalty ahead-of-the-drill should carefully check on the nature of the royalty offered, the location of the acreage being drilled in relation to producing or drilling wells, the geologist's written opinion of prospects, the nature and amount of operating and management expense that may be charged against production, the nature of the drilling contract, etc.

The prospective purchaser of a Producing Royalty should also carefully check the nature of the royalty offered. He should also consider the location and condition of the well, its present rate of and probable future rate of production, the price of crude oil, and the probable rate of return of capital and profit.

Much of this information will be found in the 'Offering Sheet' which must be submitted to each prospective purchaser of a royalty. More will be found on the Royalty Certificate, and in the Royalty Trust Agreement.

Reprinted from C.O. Nickle's "Valley of Wonders",1942
From, Historic Turner Valley, Cradle of Westen Canada's Oil and Gas Industry, pg 95-96